The Pound’s Inevitable Devaluation Arrives

Over the past two weeks central bankers in Egypt have been implementing a managed devaluation of the local currency. The Egyptian pound has dropped from 7.14 Egyptian pounds against the dollar on January 18 to roughly 7.60 Egyptian pounds where it stands today. Many analysts expect the local currency to fall even further.  

Since 2012 the Central Bank of Egypt (CBE) has periodically auctioned dollars to banks, which in turn sets the rate at which banks can sell dollars, effectively giving the CBE control over the official exchange rate. The exchange rate set by the CBE held relatively steady for most of last year, with the only real substantive devaluation in the post-revolutionary era happening in early 2013.

Managing a local currency in an economic and political atmosphere as chaotic as it has been in Egypt is far more an art than it is science. Assuring monetary stability in Egypt—in its simplest form—has been a balancing act between allowing the pound to depreciate and fixing the pound, keeping it artificially strong. The former is necessary for reducing foreign investor concerns over foreign exchange risk. The latter keeps import prices low and in turn keeps inflationary pressures at bay, as well as any populace backlash that it might spur.              

Improving the Investment Climate

From the perspective of the foreign investor, foreign exchange risk is a central concern. This is the risk of the pound devaluing for a foreign investor who’s holding an investment in Egypt. While any foreign investment will include some level of foreign exchange risk, short-term risks in Egypt are much more obvious due to an active foreign exchange black market. Black markets emerge when strict controls are placed on the official rate, providing the market place with a true rate of exchange based on the forces of supply and demand. The black market rate in Egypt prior to the devaluation of the official rate on January 18 stood at 7.75 Egyptian pounds per dollar, or roughly 8.5 percent higher than the official rate. This differential represents an additional cost to any foreign investor looking to invest in Egypt, a cost that the government realizes needs to be eliminated to fully harness foreign interests in the country.

With the much-anticipated economic summit taking place on March 13-15, it’s no surprise the central bank is now taking action with the pound. The summit will unveil numerous investment projects amounting to billions of dollars in investment opportunities geared toward both the public and private sectors. The summit will showcase grand mega-projects like the Suez Canal project, while laying out Egypt’s economic plan over the next decade. Leading up to the event, the government is also tackling investor concerns like foreign currency risk, as well as implementing new investment laws and settling legal disputes.

Coupled with the need to appease foreign investors, mounting pressure on foreign currency reserves is another reason central bankers are feeling compelled to let the pound depreciate. Foreign currency reserves, which have dropped over $20 billion over the past four years, are essentially the ammunition needed to maintain a strong pound.  With billions of dollars expected to be paid out in the near-term, maintaining the official rate will become increasing more difficult. These outstanding debts include $3.1 billion owed to international oil and gas companies, $0.7 billion owed to the Paris Club, and $0.5 billion owed to Qatar, while recent payments of $2.1 billion to foreign oil and gas companies and $2.5 billion returned to Qatar have added additional pressure on reserves as well.

The Strong US Dollar Adding Pressure to Devalue

Egypt’s de-facto dollar-peg places it in the crosshairs of global currency rebalancing, a very precarious position to be in. Over the past year as the US economy outpaces its global peers, the US dollar has spiraled upward against other currencies, bringing the Egyptian pound along with it. This has created an artificially strong Egyptian pound as currencies weakened throughout the rest of the world, and in particular other emerging markets. The strong pound is bad news for Egypt’s exporters—therefore bad news for Egypt’s foreign currency reserves—that now have to compete with other markets that are benefiting from a weaker currency.

The impact of the strengthening dollar on Egypt’s trade balance has yet to fully materialize. The most recent trade data, from July through September 2014, registered a $1.4 billion deficit compared to a $609.6 million surplus from the same quarter of the previous year – clearly a move in the wrong direction, as more dollars are leaving the country than coming in. This data also doesn’t account for the dollar’s accelerated move upward, which took place in the last few months of 2014, meaning the trade deficit will likely get worse before it gets better. Whatever the actual impact, with foreign currency reserves currently sitting at just over $15 billion, there isn’t much ammunition left to weather a drop in exports, especially in light of the billions expected to be paid out in the near future. 

Rising Prices on the Horizon?

Generally speaking expectations are that the foreign exchange black market will be eliminated by the economic summit in mid-March. Mohamed El Sewedy, the head of the Federation of Egyptian Industries, a leading industrial trade group, recently stated he expects the pound to hit 8.00 Egyptian pounds to the dollar by the summit, which is slightly above the current black market rate. Regional brokerage firm, Emirates NDB issued a report forecasting a 8.00 Egyptian pounds rate as well, while suggesting the pace to reach that point may be far sooner than mid-March. Another local brokerage firm, in a note to clients, forecasted the pound to increase to a minimum of 7.75 Egyptian pounds to the dollar, the level the pound traded in the black market prior to the start of the devaluation.

Whatever the outcome, Egyptians should expect to see some eventual rise in prices on certain goods. If the devaluation pushes the pound to the 8.00 Egyptian pounds to the dollar level by March, that would represent a 12 percent depreciation in less than two months. The price increase will be most pronounced in imported goods, like petroleum products, wheat, and foodstuffs. Inflationary headwinds, however, are blowing in Egypt’s favor. Oil prices have collapsed over the past seven months, giving Egypt’s central bankers some much-needed breathing room. Petroleum products make up a significant slice of Egypt’s consumption—in the last fiscal year it accounted for 28 percent of the overall all import bill, or $13 billion. This is expected to have a significant offsetting effect on future inflationary pressures and undoubtedly made it much easier for Egypt’s central bankers to begin the pound’s devaluation. 

Fred Jasins is a Senior Economic Researcher at the American Chamber of Commerce in Egypt

Image: Photo: Egypt's pound notes are pictured in stacks of 100 as employees count money at an exchange office in downtown Cairo June 5, 2014 (Reuters)